Google’s On2 Technologies Acquisition Is At The Mercy Of Merger Arbitrageurs

We live in an era of bumps in merger payments that the buyer thought had been negotiated, and Google (GOOG) is about learn this the hard way in its $106 million acquisition of On2 Technologies (ONT). As the stock market continues to rally shareholders whose companies get acquired are depressed to see that they are stuck with stale valuations from the time their mergers were first negotiated. In the meantime, Facet (FACT), Diedrich’s (DDRX), Hiland and others see their buyout prices bumped up. So we have sympathy for the owners of On2 Technologies who refuse to vote in favor of the acquisition of their stock by Google for $0.60 worth of Google stock.

That’s not $0.60 in cash but $0.60 worth of stock independent of Google’s stock price. The problem is that $0.60 worth of Google stock are a lot fewer shares today than back in August when the merger was announced. Google has since risen from the $450s to the $580s, or 29%. The merger consideration has remained constant $0.60. Had management negotiated a fixed exchange rate of, say 0.0013 shares of GOOG for each ONT, then shareholders would receive $0.77 worth of Google stock for their shares now.

The flipside of a constant merger consideration is that it has become much less dilutive for Google. Instead of issuing roughly 235,000 shares based on Google’s August share price, Google will now have to issue only 182,000 shares (assuming the VWAP for GOOG will be around $580).

Management is in a frenzy to line up enough votes to get the deal approved in the December 18 shareholder meeting. Every day another SEC filing is made extolling the advantages of the deal and threatening the dire consequences if shareholders vote it down. This is a clear sign that they lack votes to close the deal.

Merger arbitrageurs are the joker that will determine the outcome of the shareholder vote on December 18, The arbitrage community holds a significant share of On2. Technologies. We attribute holdings some 15% of the shares to holdings by arbitrageurs, based on our analysis of 13F holdings data collected by Whale Wisdom:

Name

Holdings on 06/30/09

Percentage on 6/30

Holdings on 09/30/09

Percentage on 9/30

Change in shares

ARBITRAGE & TRADING MANAGEMENT CO

-

-

6,545,681

3.71%

6,545,681

SHOREWATER ADVISORS LLC

-

-

5,313,966

3.01%

5,313,966

ARNHOLD & S. BLEICHROEDER ADVISERS, LLC

-

-

2,631,744

1.49%

2,631,744

LOEB ARBITRAGE MANAGEMENT, LLC

-

-

2,290,893

1.30%

2,290,893

GLAZER CAPITAL, LLC

-

-

2,147,252

1.22%

2,147,252

CENTAURUS CAPITAL LP

-

-

1,803,675

1.02%

1,803,675

AQR CAPITAL MANAGEMENT LLC

-

-

1,604,076

0.91%

1,604,076

GLG PARTNERS, INC.

-

-

1,348,228

0.76%

1,348,228

WATER ISLAND CAPITAL LLC

-

-

1,026,059

0.58%

1,026,059

BARCLAYS GLOBAL INVESTORS UK HOLDINGS LTD

1,003,273

0.58%

999,683

0.57%

-3,590

GAMCO INVESTORS, INC. ET AL

-

-

722,969

0.41%

722,969

CREDIT AGRICOLE S A

-

-

722,466

0.41%

722,466

CALIFORNIA PUBLIC EMPLOYEES RETIREMENT SYSTEM

367,430

0.21%

486,430

0.28%

119,000

DIMENSIONAL FUND ADVISORS LP

424,063

0.25%

423,263

0.24%

-800

HARRIS FINANCIAL CORP

-

-

305,000

0.17%

305,000

GEODE CAPITAL MANAGEMENT LLC

185,014

0.11%

272,299

0.15%

87,285

CNH PARTNERS LLC

-

-

257,729

0.15%

257,729

LONGFELLOW INVESTMENT MANAGEMENT CO LTD PARTNERSHIP

-

-

200,000

0.11%

200,000

UBS AG

845

0.00%

199,995

0.11%

199,150

VERITABLE, L.P.

252,400

0.15%

118,600

0.07%

-133,800

RENAISSANCE TECHNOLOGIES LLC

-

-

114,000

0.06%

114,000

BANK OF NEW YORK MELLON CORP

112,490

0.07%

112,490

0.06%

-

NORTHERN TRUST CORP

96,374

0.06%

110,345

0.06%

13,971

MORGAN STANLEY

49,292

0.03%

104,325

0.06%

55,033

KNIGHT CAPITAL GROUP, INC.

-

-

62,353

0.04%

62,353

HUNTINGTON NATIONAL BANK

50,000

0.03%

25,000

0.01%

-25,000

BLACKROCK INVESTMENT MANAGEMENT, LLC

19,400

0.01%

19,400

0.01%

-

FISHER ASSET MANAGEMENT, LLC

17,700

0.01%

17,700

0.01%

-

PRUDENTIAL FINANCIAL INC

10,100

0.01%

10,100

0.01%

-

WELLS FARGO & CO/MN

2,000

0.00%

3,000

0.00%

1,000

METLIFE SECURITIES, INC

2,000

0.00%

2,000

0.00%

-

AMERIPRISE FINANCIAL INC

1,900

0.00%

1,400

0.00%

-500

VANGUARD GROUP INC

971

0.00%

1,364

0.00%

393

This was per 9/30, a full two months prior to the record date for the meeting. We would not be surprised if their holdings of shares have since doubled. As we pointed out in our book about merger arbitrage, the outcome of many mergers is driven by the arbitrage community whose holdings often reach the 30-50% range during the merger process. A study by Micah S. Officer (“Are Performance-Based Arbitrage Effects Detectable? Evidence from Merger Arbitrage,” Journal of Corporate Finance 15, No. 5 (2007), 793–812) gives examples of the percentages reached historically in some mergers.

Arbitrageurs generally try to take a quick gain and move on. With the current price of On2 Technologies the spread comes to around 20%, depending on your assumptions about commissions and the closing date. So it will be tempting for arbitrageurs to support the deal and take that quick and easy return. However, it is also possible that the arbitrage community has smelled blood and will reject the deal, challenging Google to increase its consideration. Some of the arbitrageurs on the list are of the more aggressive variety and we would not be surprised if they challenged management.

For Google, this is its first purchase of another public company. So they are still learning and probably won’t mind bumping the price, especially not if the transaction is so small that it is a mere rounding error in their financials. They simply have to increase the exchange ratio to the level they were willing to pay back in August. That would boost returns to shareholders significantly and win over the support of the arbitrageurs.

We doubt that the transaction will collapse completely. It makes sense for Google from a strategic point of view. Building their own video compression software is certainly a possibility, but in the typical tradeoff between buy or build they are probably better off acquiring a firm that has a technology that actually works. Not to mention that in acquiring On2 Technologies they can use the technology right away. Time is of the essence if they want to use video as a driver to push their Android operating system into the mobile market. Therefore, we think that Google will eventually increase the exchange ratio to 0.0013 so that investors get as many shares as they would have in August. There remains upside in On2 Technologies beyond $0.60.

A lot of the shareholders of On2 are voting their shares through the recently launched site at http://www.moxyvote.com. Moxy Vote published the shares voted at the end of last week on its blog. Tomorrow, the site may release the final numbers.

If the shareholders agree to accept and approve the offer from Google the merger arbitrageurs may experience an unpleasant surprise. They may not realize all the gains they anticipated. The exchange ratio was to be determined from a 20 day volume weighted average of Google stock trades. The official announced exchange ratio is 0.001. With an offered price of 0.60 for each share of ON2 Technologies, it implies a volume weighted average trading price of Google at $600 per share over the last 20 trading days. It has not. Therefore the calculated exchange ratio should be a little bit higher (.001XXX).

How do we explain the apparent difference between the calculated exchange ratio based on the 20 day volume weighted average price and the official exchange ratio of 0.001? Is this perhaps due to a rounding adjustment ?

If the proposal is agreed to at the shareholders meeting, for example at the present price that Google is trading at, shareholders can expect to receive approximately 1% less for their shares attributable to the difference between the calculated exchange ratio and the official exchange ratio. One percent does not sound like a significant difference, but for the merger arbitrageurs whom you have delineated in your article, who many time realize gains on thin margins, it could significantly impact their gains. For example a 1% difference due to a rounding of the exchange rate on a 3% margin would result in a diminution of 1/3 of the anticipated gain. And if the margin was 2%, then the merger arbitrageurs would only receive HALF of the gains they thought they might be realizing when they voted their proxy.

I think it would have been better, more clear, and more precise if the actual exchange ratio had been specified in the proxies that have been sent and not determined after the votes have been cast.

It is interesting that the merger arbitrageurs, the group that may be the swing vote to decide the issue, may experience the most impact between the purchase and sale price from the delta between the calculated exchange rate based on the 20 day weighted average and the official exchange rate.

Let’s see if you can go 2 for 2 here (highland and on2). Share holder apathy is really really strong in this stock and I’m not sure even if they raised the price they could even get enough vote to actually do anything.

I just saw a merger where they tried to liquidate the company and return the money to the stock holders, the stock holders didn’t vote so they ended up giving the entire cash balance to another company just so they can shut down operations and get their bonus’. (LJPC was the ticker). Apathy can be a real (expensive) pain in the ass for an attentive share holder.

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